It was three and a half weeks ago (May 14) that I wrote a post “Inflation Expectations Are Falling; Run for Cover” in which I called attention to the fact that inflation expectations, which had been rising since early in 2012, had begun to fall, and that the shift had coincided with falling stock prices. I included in that post the chart below showing the close correlation between inflation expectations (approximated by the breakeven TIPS spread on 10-year constant-maturity Treasuries and 10-year constant-maturity TIPS)
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Then I noted in two posts (May 24 and May 30) that since early in May, I had detected an anomaly in the usual close correlation between short-term and long-term real interest rates, longer-term real interest rates having fallen more sharply than shorter-term real interest rates since the start of May. That was shown in the chart below.
I thought it would now be useful to look at my chart from May 14 with the additional observations from the past three weeks included. The new version of the May 14 chart is shown below.
What does it teach us? There still seems to be a correlation between inflation expectations and stock prices, but it is not as close as it was until three weeks ago. I confirmed this by computing the correlation coefficient between inflation expectations and the S&P 500 from January 3 to May 14. The correlation was .9. Since May 14, the correlation is only .4. That is a relatively weak correlation, but one should note that there are other three-week periods between January 3 and May 14 in which the correlation between inflation expectations and stock prices is even lower than .4. Still, one can’t exclude the possibility that the last three weeks involve some change in circumstances that has altered the relationship between inflation expectations and stock prices. The chart below plots the movement in inflation expectations and stock prices for just the last three weeks.
One other point bears mentioning: the sharp increase in stock prices yesterday was accompanied by increases in nominal and real interest rates, for all durations. That is not an anomalous result; it has been the typical relationship since the early stages of the Little Depression. Expected inflation implies increased nominal rates and increased borrowing costs. Moreover, expected inflation has generally been positively correlated with real interest rates, expectations of increased inflation being correlated with expectation of increased real returns on investment. So the conventional textbook theory that loose monetary policy increases stock prices and economic activity by reducing borrowing costs is simply not reflected in the data since the start of the Little Depression.
Uneasy Money 
“he correlation was .9. Since May 14, the correlation is only .4. That is a relatively weak correlation, but one should note that there are other three-week periods between January 3 and May 14 in which the correlation between inflation expectations and stock prices is even lower than .4. Still, one can’t exclude the possibility that the last three weeks involve some change in circumstances that has altered the relationship between inflation expectations and stock prices.”
Correct me if I am wrong, but if the correlation between stock prices and inflation goes down doesn’t that mean that stock prices are no longer surprised by changes in inflation?
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If the typical relationship is for stock prices to increase with nominal and real rates, then how is it that since the little depression began, stocks are up nearly 100% and yet nominal and real rates have declines?
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Open request. I have attempted a lay-person friendly Easy Guide to Monetary Policy. If people could have a look at it and make comments or suggestions, that would be good.
http://skepticlawyer.com.au/2012/06/06/easy-guide-to-monetary-policy/
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Martin, Sorry, but you are wrong. The correlation that I am talking about is not between stock prices and inflation, but between stock prices and expected inflation. If the correlation between stock prices and expected inflation weakens, it could simply mean that other factors that affect stock prices were changing a lot and therefore accounted for most of the movement in stock prices.
bubblesandbusts, Expected inflation is correlated with inflation, but it is only one of many factors that affect inflation. Statistically the relationship is telling us that if we hold all the other factors that affect stock prices constant, what percentage change in stock prices is associated with a one basis point change in expected inflation. Just because that “partial” or ceteris paribus relationship is positive doesn’t imply that stock prices overall could not go up while inflation expectations overall went down. But in fact when stocks bottomed out, inflation expectations were even lower than they are now.
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“Moreover, expected inflation has generally been positively correlated with real interest rates, expectations of increased inflation being correlated with expectation of increased real returns on investment.”
David, what about the Mundell-Tobin effect?
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David,
thanks for your answer; that was rather badly phrased by me.
What I meant to say was that if inflation expectations differ across horizons then the stock market might respond to inflation expectations over a different horizon than the you’re measuring.
What came out was something akin to that the stock market already expects inflation expectations; that didn’t make much sense.
That said, I take it the 20 year and the 10 year do not differ too much.
http://research.stlouisfed.org/fredgraph.png?g=7QQ
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Note BTW that this is the implied breakeven rate, which in theory has a time-varying risk premium when compared to the ‘true’ market expectations regarding the inflation outlook. This risk premium is likely to be correlated with risk premium on other assets, so to an extent there is an identification problem – is stocks go down, and so do breakevens to what extent is this due to the risk premium going down, and to what extent is this due to true expectations falling?
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The chart on TIPS 5 year, and 10 year yield relationship. Does draw a picture that is simple to understand. The suggestion is that both are only going one way, and that is down. Buy GOLD to protect yourself.
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Saturos, Good question. The difference is that the Mundell-Tobin effect is a comparison between two alternative equilibrium time paths with different rates of expected inflation. The case that I am considering is a disequilibrium phenomenon in which the rates of interest and inflation must adjust before reaching a steady state equilibrium time path.
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